All you need to know about Shell Company

What is a shell company?

At present, neither Companies Act, 2013 nor Companies Act, 1956 nor any other Act gives a definition for a Shell company. Efforts to define it are still being made and many recommendations have been considered.

One suggestion was given by the Organisation for Economic Co-operation and Economic Development. The definition given was, “A shell company is a firm that does not conduct any operations in the economy (other than in a pass-through capacity), but it is formally registered, incorporated, or legally organized in the economy.”

Thus, a it is a company that exists only on paper. It does not have any actual active business operations nor any significant number of assets. These companies do not engage in any economic activities but have some corporate legal personality.

How to identify a shell company?

Though there is no statutory provision in this regard, The Securities and Exchange Board of India (SEBI) has identified certain parameters for the identification of shell companies. These are:

1. No significant operation activities;
2. No significant operational assets;
3. Acting only in a pass-through capacity (like a channel for some other purpose).

Besides SEBI, there are many agencies and individuals who have also tried to lay down parameters for identifying these companies. Some parameters laid down are:

1. These entities have insignificant business activities.
2. These entities have an insignificant amount of assets.
3. They are basically set up to facilitate cross border currency and asset transfer.
4. They do not have any physical existence at the registered address.
5. Multiple companies at times have the same registered address.
6. These companies have no economic rationale of any kind behind their banking transactions.
7. These companies carry out rotational transactions of money without any apparent legitimate business.
8. High-value transactions which are inconsistent with the operations of the business.

Why are shell companies created?

Now that we know how we can identify a shell company, let’s see why these are created.

Today, Shell companies are usually associated with the following activities:

1. Tax Evasion: Many times corporations set up shell companies at offshore venues where the taxes imposed are very less. These places are known as ‘Tax Havens’. Examples of these places are Panama and Switzerland. These corporations park their assets in the shell companies and escape from paying taxes on these assets.
2. Money laundering and converting black money into white money: A lot of shell companies were discovered in 2016 when demonetization happened. This was because they were engaged in making use of black money. Many people and corporations make use of shell companies to store their surplus cash, instead of making deposits.
3. Making money off Ponzi Schemes: People or corporations may create shell companies to defraud people by offering fraudulent schemes and earning money out of it. By making use of these companies, they save themselves as when fraud is found, it is very difficult to find the actual people behind the scheme, and the only thing upon which the blame can be put on is the company (which is not of any use).
4. Hide identities of real owners: Finding the real owner of a shell company can be a problematic task as more often than not, the owners of these companies successfully hide their identities. They cannot be located as usually the registered office of the company or directors is at a completely different place, then the address submitted to the registrar.

Are shell companies always created for illegal purposes?

No, it is not necessary that a shell company is engaging in illegal activities. Though, till now we have only discussed how they can be used illegally, at times, they work within the legal limits as well. Let’s look at an illustration to understand how shell companies can work legally.

Company ‘A’ creates a subsidiary solely for looking after its HR functions. Now, this subsidiary does not engage in any form of trade or business. Because, it neither has any significant assets, nor does it have real business operations, this subsidiary can be considered as a shell company, but it is not illegal.

In  Assam Co. India Ltd. vs. Union of India, a company owning a substantial number of tea estates, producing millions of kilograms of tea on an annual basis and feeding thousands of families was termed a ‘shell company’. The court held that considering the negative implications of being branded as a shell company, it was not justified to treat the company as a shell company.

The legal reasons for which a shell company can be created are:

1. Hold or store money temporarily when the main company/ owner of the shell company is planning to start a new company.
2. If a company wants to hide its dealings with another company, which has a bad reputation, it may create a shell company solely to engage with the other company.
3. It may be created to stage a hostile takeover. This happens when a company buys another company, without the approval of the management of the target company.
4. To protect assets from lawsuits.
5. In case a company is working in a dangerous country, for instance, with rampant terrorist activities, then people may formulate shell companies to hide money in order to avoid being a target of criminals and thieves.
6. They can also be created to gain access to foreign markets.

As mentioned creation of shell companies is not an offense. However, some issues arise with establishing it. These are as follows:

1. In case a company forms a shell company offshore, it can lead to bad publicity as profits are being sent out of the nation.
2. While not necessarily illegal, using a shell company to hold assets in it, falls in a legally grey area, and could lead to legal issues. Hence, it is definitely advised not to create it.

Laws that a shell company may violate

Now that we know illegal purposes a shell compan is created for, let’s have a look at some of the laws it violates when engaging in such illegal activities.

1. Benami Transactions Prohibition (Amendment) Act, 2016, which prohibits anyone from holding assets under a fake name to avoid taxation.
2. The companies (restriction on the number of layers) Rules 2017, which restrict the number of layers of subsidiaries a company can have.
3. Prevention of Money Laundering Act (PMLA): When black money is passed through it, black money is presented as tainted money. This is punishable under Section 3 of PMLA.
4. Indian Penal Code: In case the shell company is used for engaging in Ponzi Schemes, the owners and anyone involved can be punished under Section 420 of IPC which prohibits cheating.
5. Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015.
6. The Income Tax Act, 1961: PoEM Guidelines issued by the Central Board of Direct Tax.

This blog is written by Amrit Rathi, Jindal Global Law School

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